Cryptocurrency exchange with AMM is different from traditional ones, and today we will find out how. AMM stands for “Automatic Market Maker”, which basically gives the meaning away – on such exchanges, orders are placed automatically without waiting in the order book. Most modern decentralized crypto exchanges use this concept. In this article we will find out what AMM is and give examples of popular exchanges using this concept.
Cryptocurrency is a convenient tool for trading and investing on the Internet, but the peculiarity of the first cryptocurrencies was that users could not get them before the launch of blockchain and miners. Initially, they only had 2 ways to get the assets:
- Buy equipment and mine new coins.
- Buy already mined coins from miners on one of the trading platforms.
It doesn’t seem like a big deal now, but in the crypto market before the DeFi era, users could only buy cryptocurrencies on centralized exchanges (CEXs). These exchanges used order books to create the market by matching user and market maker orders. That doesn’t seem to be a problem either, because CEXs are convenient, affordable, and safe, right? However, centralized exchanges have risks that can affect not only the company itself but also the users. The Coinbase Q2 2022 10-Q report states that since user cryptocurrency is formally considered assets of the exchange, those funds can also be used as collateral for creditors in the event of bankruptcy.
So, Crypto World tried to find a solution that would allow owners to store and exchange cryptocurrencies without being exposed to counterparty (exchange) risks. NXT and Counterparty developed the first peer-to-peer exchanges back in 2014. Early decentralized marketplaces leveraged the same order books but sought to integrate them with smart contracts to move away from a centralized operator.
In 2016, Vitalik Buterin presented the concept of an automatic market maker (AMM) for the first time, which was described in detail in the 2017 work “On Path Independence”. In Buterin’s vision, AMM is a series of smart contracts that price an asset based on the ratio of assets in the liquidity pool. The pools perform the function of market makers, but since the exchange rate in them is algorithmically set by a smart contract, counterparty risk is much lower than when working with centralized platforms.
In fact, AMM were used in the stock markets including trading in gold, oil and stocks – market makers helped the investor find liquidity to sell or buy an asset close to the public market value. The transaction is concluded when the price expectations of the seller and buyer match. In the global financial markets, this is achieved through the use of the order book.
The user places an order at a required price. This request is placed in the order book for buying and selling. There he waits for a counter offer. The operation is not complete until someone wants to make a deal at the same price. This is exactly how it works in the crypto market.
At its core, AMM is a smart contract that provides liquidity to the decentralized finance ecosystem in a way that differs from traditional order book matching. Crypto assets are traded using an automated algorithm based on funds held in liquidity pools. The exchange is therefore immediate, without waiting for a counter-offer.
AMM itself determines the market price of the token based on the ratio of the two assets in the pool. The only condition for successful trading is the presence of a sufficient amount of liquidity in the pool. To ensure this, DeFi protocols reward users for providing liquidity.
In order to interact with crypto AMM services, a user needs to know the basic elements and principles on which the work of such a platform is based:
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Liquidity is the most important indicator for any market. Liquidity determines how easy it is to exchange one asset for another.
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A liquidity pool is a smart contract containing a supply of two or more tokens. The pool does not require a counterparty for the exchange: the user simply transfers one token to the pool and immediately receives another.
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Price slippage is the difference between the expected and final value of a trade. Slippage occurs in traditional and order book markets, but AMM has greater potential for slippage. If you try to make a large trade in a small pool of liquidity, the final price may differ from what you expected.
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Liquidity Providers – Decentralized platforms do not inject their own funds into liquidity pools, instead users put assets into the pool themselves. For providing liquidity, they receive commissions from transactions in the pool and additional rewards.
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Inconstant Loss. You have provided cryptocurrency to a liquidity pool. The price of the tokens has changed from the original, therefore the number of tokens contributed will also change and you will face unrealized losses. If the price of both tokens from the pool increases, you earn. The more the price deviates from the original, the greater the temporary loss.
- Arbitrage is a way of making money on the difference in value of an asset in different markets. If ETH is cheaper in the DEX pool than in the central exchange’s cash market, then the trader buys the asset cheaply in the pool. After that, he sells it for more on the CEX.
Uniswap
Uniswap is one of the leading DEXs and also the first AMM on the market. Uniswap is powered by hundreds (if not thousands) of liquidity pools for various ERC-20 tokens, creating tremendous opportunities to generate revenue from providing liquidity.
Curve
Curve Finance is another protocol that you can use to exchange tokens and provide liquidity. Curve focuses on stablecoins as well as packaged bitcoins on the Ethereum network. The platform minimizes temporary losses by bundling stablecoins (e.g. 3Pool provides liquidity in USDC/DAI/USDT tokens) and avoiding liquid pairs combining volatile coins and stablecoins.
equalizer
The Balancer protocol is also an open-source AMM, but unlike most other exchanges that use a 50/50 asset split to create liquidity pools, Balancer allows you to create pools of up to eight different tokens . These pools are automatically balanced according to smart contracts, reducing the risk of temporary losses.
Exchanging cryptocurrencies with AMM is one of the most important components of the DeFi space. They provide access to instant liquidity in an automated mode based on smart contracts and reduce slippage risk. Such platforms are in demand among investors looking to earn passive income, as all services offer rewards to users for providing liquidity.
However, before using it, you need to weigh all the pros and cons – consider the temporary losses and the fact that decentralized exchanges are much less intuitive, so it might be best for beginners to start trading on centralized exchanges.
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